Stop Me Before I Do Something Stupid

Tips for becoming a more disciplined investor—and boosting your returns

By

Michael A. Pollock

October 3, 2012

Dieting is easier if you don't have a half-eaten cake staring at you when you open the refrigerator door. And successful mutual-fund investing is easier, too, if you limit the temptations to act badly.

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If you often feel compelled to jump on the latest market trend—or bail out during a big market drop—one solution is to turn over management of your portfolio to an adviser, for a fee. But you can also avoid common mistakes by adopting a steadier, more-disciplined approach.

Emotion long has driven investment decisions by many people—and it is particularly true this year, amid all the scary headlines about the European debt crisis and the U.S. economy's sputtering performance, says Russel Kinnel, director of mutual-fund research at Morningstar Inc.MORN-0.13% Investors continue to pull more money out of U.S.-stock mutual funds than they pump in, and yet the Standard & Poor's 500-stock index returned a flashy 16.4% (including dividends) in the first nine months of 2012 and an average of 13% a year over the past three years.

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Poorly timed buying and selling causes returns of individual investors on average to significantly lag behind the returns of the funds they invest in. Morningstar calculates that over the decade through August, investors got returns of 5.6% a year, well below the 7.3% average for all of the mutual funds the firm tracks.

But investors who have a good, long-term strategy and are sticking to it despite all the noise in the news are likely faring better, Mr. Kinnel says. "If you have a sound plan and you understand why you own certain things, that will really reduce the odds that you panic when markets go down," he says.

Here is some advice from financial advisers on how you might boost your fund-investing returns by being more disciplined:

Create an investment framework for all of your future needs

Divide your money into "buckets," each dedicated to one key goal. Dollars earmarked for a car purchase in three years might go into a bank account or a conservative, short-term bond fund. Another bucket—which you could invest in a diversified equity fund—might be dedicated to tuition payments in 15 years.

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The bucket approach can help you take an appropriate amount of risk for each goal—and keep you focused on the timing and magnitude of the goal. For a big, distant target, for instance, the slim returns you'll get from "safe" investments like U.S. Treasurys won't go very far. Hence the need for stocks. "You get paid for taking risk, not for being comfortable," says Tim Courtney, chief investment officer of Exencial Wealth Advisors in Oklahoma City.

Set up a regular schedule for adding money to the buckets while being careful to keep enough cash around in case of emergencies.

Get real about what you can expect from your funds

Many investors choose funds that have just posted several stellar years, so it isn't surprising that they expect more juicy gains, says Keith Goddard, who heads Capital Advisors Inc. in Tulsa, Okla. Then, when a fund starts to fade, investors rush to dump it.

Neither approach necessarily makes sense. For starters, whatever the asset class, be realistic about your return expectations. Then, make careful notes about each fund so that when you review its performance at year-end, you'll remember why you bought it and how you thought it would benefit your overall portfolio.

Consider if a fund is having an off year because of a development at the fund firm—such as the departure of a star manager—or whether it is down because investors generally are steering away from the area the fund invests in, says Eric Ross, principal at Sequoia Wealth Counsel, Cincinnati.

Industry data show that even top managers often slip in peer-group rankings in about three of every 10 years. The three years may be consecutive.

Have a plan for how you react: Unless there has been some fundamental change in the management, give a fund at least two years to recover, advisers say. If it is still seriously lagging behind its peers, do some more research before selling.

Zag when others are zigging

Resist the temptation to follow everyone into a sizzler. Doing that could mean you are buying into a fad at its peak. As dollars pour into a hot fund, it also can overwhelm the manager's ability to effectively invest the new money, leading to lower future returns, says Lewis Altfest, principal adviser at New York-based Altfest Personal Wealth Management.

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A better strategy is to look for a fund that has a solid long-term record and a good manager, but has just had one or two years of negative returns, he says. The odds are that the fund is due for a rebound soon.

Mr. Altfest's firm recently decided to wager on a recovery in . It ranks in the top 10% of Morningstar's foreign-large-blend grouping for 10 years, but last year suffered a 14% drop as markets reacted to the European debt mess. So far this year, through September, it is up 13.5%.

If you tend to panic during market meltdowns, pick funds that are less volatile than the market

Funds that invest in a broad mix generally gyrate less. One possibility is , which has about 60% exposure to stocks and 40% to bonds, says Steven Rogé, an adviser in Beverly, Mass. Because its portfolio contains a diverse range of stocks and bonds, it can be an effective single solution for people who don't want to keep a close eye on their portfolios, he says.

Mr. Rogé also likes , a moderate-target-risk fund. It has considerable flexibility. At times, the fund's manager, Steven Romick, has held as much as 40% of the portfolio in cash while waiting for investment opportunities.

The fund ranks in the top 3% of its Morningstar grouping for 10 years.

Another equity fund that offers low volatility and strong performance is , a large-cap-value offering, according to S&P Capital IQ.

The fund has a volatility measure, or beta, of 0.65, meaning that its value tends to move only about two-thirds as much as that of the S&P 500.

It ranks in the top 20% of its Morningstar grouping for five years.

Whenever you buy or sell a fund, consider the impact on your overall portfolio

Although some of your funds usually will be lower on any given day, building a diversified portfolio can help preserve portfolio value against a big drop in any one market area. You may lose that benefit if you're too quick to dump the fund with the most mediocre return in a quarter or year.

Consider the portfolio managed on behalf of a conservative investor by Sunit Bhalla, a financial planner in Fort Collins, Colo. It contains 23 funds, including U.S. and foreign stocks and several bond funds.

During this year's first quarter, as stocks rallied, the portfolio's holding jumped nearly 20%, contributing to a 7.4% overall gain in portfolio value. The portfolio's laggard investment fund during the quarter was , which represents about 7% of total holdings. It rose just 1.8%.

But in the second quarter, with stocks retreating, the Oakmark equities fund shed more than 12%. In contrast, the Pimco bond fund gained 3.6%, outpacing every other holding in the portfolio managed by Mr. Bhalla. The portfolio lost only about 2% for the quarter, even though nearly every fund besides the Pimco offering had a negative return.

"If I had sold the Pimco fund and put more money into the Oakmark fund, it would been devastating to overall performance for the quarter," says Mr. Bhalla.

The Readers Weigh In: Investing Mistakes

I'm a passive investor, but I would read an article by Larry Swedroe and think I needed to tilt toward small-cap/value stocks. Then I'd read an article by Allan Roth and think "total market" funds were the way to go. David Swensen would get me thinking I needed to include a REIT fund. Any of the strategies are reasonable, but I just couldn't decide and would often be tempted to switch from one to another. Finally, I switched to a simple all-in-one fund.

-- Mike Piper

Where is the option: "Being tricked into thinking active managers can beat the market over an extended period"?

-- Eric

When the .com bubble burst, and I wasn't smart enough to roll my 401(k) over to safer investments, costing me thousands.

I like your tip "zag when others are zigging". It's so easy to get sucked into fads and trends if you're managing your own investments—especially if you find yourself tight on time and are not able to do adequate research before putting money down. It's a great idea to be cautious like this. In reality, you'll save money in the long run. Thanks for sharing your advice with us. http://www.tisonfinancialgroup.com

Thanks for the interesting article! I liked when you said that managing your investing can be a patience game. Like the metaphor you mentioned about leaving a cake out when you shouldn't eat it, it would probably be wise to make sure that investing is controlled. My brother is fairly good at investing because he has taken some classes on it. I wonder what kinds of tips he could have about investment and similar issues. http://fogelcapital.com

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